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Ticker: IBM

Rating: Maintain at Buy

Thesis:

The application software industry tends to feature high-growth names like Akamai (AKAM), Linkedin (LNKD) and Equinix (EQIX) with large PEs as well as software giant Google (GOOG), but we believe that out of the group the most compelling name is the blue-chip IBM. In this article, we will discuss our thesis on why you should buy IBM as well as briefly discuss some of the competitors in the landscape.

IBM was selected as one of our top picks for 2013 as the company has incredible upside and value from current levels. We see, as can be seen below, the company growing operating income by 20%-25% in 2013. We will discuss why we see such great growth below. We have brought down expectations fairly significantly after the company seems unlikely to achieve some of our earlier expectations for the FY due to global demand issues as well as a potential hangover from government spending that seems likely. Despite our price target cut, we still believe that IBM has a lot of potential for 2013 due to cyclical strength that will occur as the company benefits from the 2012 release of its new Power 7+ servers and PureSystems cloud service. The company has easy comps for 2013, and we believe that shares should start to take off this year on cyclical hardware/software growth. What we like best about IBM, though, is the company's continued strength of economic moat and shift to a service-based model that is more profitable.

The release of the Power 7+ server will not only produce a strong sales surge from new hardware but additionally the software that accompanies this new hardware, and we believe that investors are not properly pricing in this cyclical growth given the 14 current PE vs. 11 future PE based on 2013 EPS expectations. The last update of servers (Power 7) was in early 2010, and the company saw a strong surge in revenue and EPS growth on the back of that cycle. With the Power 7+ processor released in late 2012, the company will easily beat year/year comps.

On top of the release of the 7+, the company's PureSystems cloud system was released in mid-2012. Cloud is the future in application software. Companies like AKAM and EQIX have built strong businesses on the back of the cloud system. The company's cloud system was a necessary development as competition rises in the enterprise software/hardware industry. One benefit that IBM has over other companies is that it is a hardware to software expert that has been creating servers and relationships for years. The company is, additionally, building much more highly unique cloud systems through its PureSystems offering. The company has built a very interesting three-prong family of services in the cloud: PureFlex, PureApplication and PureData. PureFlex allows customers to integrate storage and networking into one system, which is a fairly classic cloud model. From there, the company developed PureApplication, which will allow customers to build applications for clients within a cloud network. PureData helps deliver data to applications. The three together build a solid software base that we believe will continue to grow as the company can combine its strength in hardware with complementing software.

What may be even more appealing for the long term about IBM is the shift in the way the company makes money. What used to be a hardware-based business has turned into a service-based company. IBM makes nearly 60% of all its profits from recurring services: business analytics to IT to consulting to outsourcing. The applications software portion of the company that sells technology etc. is not as predictable and it's much tougher for the company to create an economic moat. Yet, the recurring services are built around relationships and long-term standing of the company. The company's shift away from just selling servers and software to accompany them has made it much more sustainable. At the same time, the introduction of new software and hardware gives the company a lot of really strong cyclical strength. In 2000, the company made about 35% of income from hardware. In 2011, that number was down to 16%.

Yet, not everything is looking up at IBM. For one, the company has to deal with the current situation going on in Washington, DC. One of the main reasons we have reduced our expectations is we believe that the company will suffer from spending cuts from the government. The government is one of the largest customers for IBM, and if it were to cut spending, the company would get hurt. Additionally, we believe that its shift to the cloud does make some of the business less predictable than in the past, which adds some volatility and beta that was not previously seen. Further, we reduced our overall expectations moving forward as the company underperformed our targets in some of the latest quarters.

IBM remains one of the healthiest companies in the marketplace with great cash flow, balance sheet and profit ratios. The company, currently, operates with about $16B of free cash flow, which has increased from just over $9B in 2006. The company's strong FCF/sales ratio is another sign of general strength for the company. The company currently operates with a 15.5% FCF/sales margin, which is well above a healthy rate at 5%-10%. Looking at IBM's balance sheet, the company currently holds nearly $12B in cash/cash equivalents, and it has a number of very promising key ratios.

What we like to see most in investments is a company that is increasing its profitability ratios. One of the knocks on IBM has been that as it moves from hardware to software, IBM may see margin compression. The opposite is occurring. The company has moved toward more recurring services that have allowed it to see return on assets increase from 3.9% to over 14% in the TTM over the past 10 years. ROA has increased every single year without any decline. This means that the company continues to increase the profitability of assets despite its growth, meaning the company invests in solid acquisitions and in-house R&D.

In our Application Software coverage, we believe IBM is the best company to buy. We have Google Hold-rated as we believe the company suffers from too many assets and not enough profitability. You can read our full report on Google here on Seeking Alpha. We have Linkedin rated as a Sell currently as we believe the company is vastly overvalued. We have Equinix Hold-rated as well as we believe the company has now appropriately priced in its growth potential. Akamai is Sell-rated as well. Our LNKD, EQIX and AKAM reports will be available soon.

2013 could be quite a comeback year for big blue, and we believe that the release of new servers, strong recurring profits/revenue, and a push toward a solid cloud lineup will make IBM a solid company for the new year.

Price Target:

Ticker

New Price Target

Old Price Target

New Rating

Old Rating

New Buy/Sell Range

IBM

$249

$285

Buy

Buy

$197/$275

The following price target was configured through a five-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it with current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

18101

22500

23200

23750

20601

Taxes

4254

5288

5452

5581

4841

Depreciation

4712

4900

5000

5050

5012

Capital Expendit.

-4130

-4300

-4450

-4700

-4930

Working Capital

100

100

100

100

100

Available Cash Flow

14329

17713

18198

18419

15742

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for IBM: 6.00%

2012

2013

2014

2015

2016

PV Factor of WACC

0.9434

0.8900

0.8396

0.7921

*

PV of Available Cash Flow

13518

15764

15279

14589

*

* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2%-6%; 4% is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you the cap rate.

Cap Rate for IBM: 5.00%

2016

Available Cash Flow

15742

Divided by Cap Rate

5.00%

Residual Value

314835

Multiply by 2016 PV Factor

0.7921

PV of Residual Value

249379

Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

59151

PV of Residual Value

249379

Cash/Cash Equivalents

11909

Interest Bearing Debt

33667

Equity Value

286772

We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.

Step 5.

Divide equity value by shares outstanding:

Equity Value

286772

Shares Outstanding

1130

Price Target

$249

In the end, we have found that IBM is worth around $249, which we believe accurately reflects the company's five-year projections.

Profitability:

Q1-Q3 2012

Q1 - Q3 2011

Operating Margin

17.3%

20.1%

Gross Margin

46.7%

45.7%

Return on Equity

50.0%

51.5%

IBM's profitability margins have declined year/year as global demand has lowered, but the company still operates with very solid operating margins and ROE. How do these companies compare with competition?

Equinix operates with a 22% operating margin, 50% gross margin, and 2% return on equity. Google operates with a 28% operating margin, 54% gross margin, and 12% return on equity. Akamai operates with a 5% operating margin, 95% gross margin, and 6% return on equity. Linkedin operates with a 5% operating margin, 71% gross margin, and 1% return on equity. As we can see, IBM operates with a middle of the pack operating margin compared with other application software companies. IBM is actually fairly low on gross margin, but it is also the largest, oldest of the companies. Its return on equity, however, is top-notch. The company's profit margins may be middle of the pack, but it makes the most money off its assets.

Value:

Current

Industry Average

P/E

14.0

27.9

Future P/E

11.7

N/A

One of the most promising aspects of IBM, as we have mentioned, is its strong value. The company is quite under the industry average, and we believe its value shows a lot of reason to buy. How does IBM compare with competitors?

Equinix has a PE over 84 and future PE near 64. Google has a PE of 22 and future PE of 15. Akamai has a PE of 38 and future PE of 20, and Linkedin has a PE of 715 and future PE of 87. As we can see, IBM lags nearly all other application software companies. We believe its cheap multiple is an attractive buying opportunity.

Good Investing!

Source: In Application Software Industry, IBM Is Best Buy Of 2013